Meltdown 101: Why government may swap bank stakes

By CHRISTOPHER S. RUGABERAP Economics Writer

Thursday

Feb 26, 2009 at 3:00 PM

WASHINGTON – A technical change announced by financial regu-lators Monday could mean the gov-ernment will end up owning a much bigger chunk of the nation’s largest banks – without necessarily using more taxpayer money.

The Treasury Department, Federal Reserve and other financial regula-tors, in an unusual joint statement, said they will now consider convert-ing previous government invest-ments in the banks from preferred shares to common shares.

What’s the difference? For one thing, such a move would give the government potentially larger owner-ship stakes, depending on how the conversions are calculated. In the case of Citigroup Inc. and Bank of America Corp., the government has already invested $45 billion in each, far above the current market value of each company – so the government could end up owning a substantial share of those banks.

At the same time, the regulatory agencies made clear they want to keep the banks in private hands and avoid government control, or “na-tionalization.”

Here are some questions and an-swers about the potential ramifica-tions of the change for banks, their shareholders and taxpayers.

Q: First of all, what’s the difference between preferred shares and com-mon shares?

A: One difference is that owners of preferred shares are one step ahead of common shareholders in their claims on a company’s assets. That means they get paid first if a com-pany goes belly-up. On the other hand, holding common stock gives an investor more of an actual owner-ship stake in a company, and more influence over how the company op-erates.

Q: Could switching preferred shares to common ones help the banks?

A: Yes. Banks currently pay a divi-dend of 5 percent on the preferred shares they issued to the government in return for the bailout funds they began receiving last October. The common shares wouldn’t include a dividend, allowing the banks to hold on to that capital.

More importantly, analysts said, boosting a bank’s common stock increases its “tangible common eq-uity,” a measure of its capital that is considered the most conservative estimate of a bank’s financial health. Tangible common equity is what a bank would have left after paying off all its creditors and depositors.

Preferred shares are have some characteristics of debt, so their hold-ers need to be paid off if a company fails. Common stock does not need to be paid off in this scenario. So having more common stock rather than pre-ferred stock results in a higher tan-gible common equity.

Q: Why does “tangible common equity” matter anyway?

A: It matters because shareholders, and potential borrowers, don’t want to put money in an institution unless it’s considered healthy. This measure is considered the most reliable de-termination of a bank’s health.

Until recently, regulators have fo-cused more on “Tier 1 capital,” an-other measure of a bank’s health that includes intangible assets such as tax losses that can be used to reduce future earnings, which helps at tax time. But banks are doing so badly, it’s not clear when many of them will have future earnings at all.

As a result, the financial markets no longer trust the Tier 1 capital fig-ures, said Karen Shaw Petrou, man-aging partner at Federal Financial Analytics, a consulting firm. That has forced regulators to focus more on the tangible common equity, Petrou said.

Q: What will this change do to shareholders?

A: If the government owns a greater proportion of the banks, ex-isting shareholders would see their shares diluted, potentially reducing their cut of future profits.

But the shares of most banks jumped today on the government’s announcement, because it stopped short of a government takeover of banks, which would likely wipe out existing stockholders.

Q: What does this mean for tax-payers?

A: Common shares absorb losses before preferred shares, which means taxpayers would be at greater risk if banks continue to record losses based on billions of dollars worth of rotten assets, such as dodgy mortgages, as many analysts expect they will.

On the other hand, taxpayers would benefit more if the common shares rebounded from their current lows.

In addition, the government would have voting rights on the banks’ boards, giving taxpayers a greater say in how the institutions operate.

Q: Would this move be enough to help banks recover?

A: Possibly, but only if the govern-ment also kicks in more money. Paul Miller, a banking analyst at FBR Capital Markets, estimated earlier this month that the financial industry needs “at least” $1 trillion in addi-tional tangible common equity.

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